Wednesday, September 28, 2011

Are You Worried About the Markets?

Just when you thought it was over, the market dipped – again.

It’s been 3 years since 2008 and it has become all too apparent to even the strongest optimists that we are in a global recession.
Serious volatility seems to be a constant factor when investing in the equity markets.
From the interest rate hike on September 16th with suggestions of still more hikes to come, to spiraling inflation that seems immune to interest rates, to petrol price fluctuations, to 1000-points dips on the Sensex in 2 trading sessions, the Indian retail investor should by now have developed nerves of steel.

Its times like these that call for two things:

1. A deep breath
2. A brief recap of the wise investing methods that we all know but tend to forget when under stress

Lets get started.

1. Rupee Cost Averaging is your friend

Over time and in many market situations we have seen that Systematic Investment Plans deliver consistent returns when compared to lump sum investing. Since you are investing a fixed amount at fixed intervals, you will end up buying more units when NAVs are low and fewer units when NAVs are high.

This automatically means that when the markets are falling, the last thing you should do is stop your SIPs. A bad time for the markets is a good time to buy into them. Those investors who kept their SIPs going through the fall of 2008 have that portion of their portfolios very much in the black, and that happened because they bought low.

2. Diversify, diversify, diversify

Sit down today with a pen and paper (or for the computer savvy, with an open excel sheet) and start listing your net worth. Your home, if you own it, will be your biggest asset. Make a note of how much you have in direct equity, equity mutual funds and PMS if any. List all your fixed income i.e. PPF, EPF, Bank FDs, FMPs, NSC, KVP etc. Make a note of other assets such as gold (ETF and physical whether coins, bars or jewellery), and cash in your bank accounts.

Once this is done you’ll be able to see how much of your wealth is in real estate, equity, debt, gold and cash. Ideally, depending on your life goals, you should have a certain amount in equity, debt and gold.

If your goal is less than 3 years away, stay away from equity. This might seem like a long time to not take advantage of the growth offered by equity markets, but think about this – if you had a goal such as putting the down-payment on a house in 2011, and you invested some money into equity mutual funds in 2007, 4 years later, you would be lucky to get your principal back intact. So remember – 3 years or less means no equity exposure, only fixed income.

For a goal that is 5 years away, your exposure should be predominantly fixed income and gold, with very little equity exposure (not more than 25%).

As the time to your goal increases, your equity exposure can go up. For a goal that is 10 years away, you can have 75% exposure to equity, with 10% in fixed income and 15% in gold.

3. A Little Self Awareness goes a Long Way

This is a 2 part point.

1. First – Ideally, you should be completely aware of your own financial situation, but to begin with its fine to start with getting a handle on your expenses. Know exactly how much you spend on groceries, fuel / travel, utilities including phone and internet bills, maid salaries, society dues / rent, entertainment, personal expenditure and additional family expenditure each month. Whatever this figure is, keep at least 6 times this amount set aside in your bank account and a liquid plus fund.

The financial planning rule is to keep 6 to 24 months worth of expenses in a safe, easily accessible investment. Note that 6 months expenses is the minimum safe amount.

2. Second – Know your risk tolerance.

If you are nearing retirement, or nearing any financial goal like buying a car, taking a family vacation, spending on your child’s education or marriage, buying a house, or are already retired, equity is not the place for these funds. Your risk tolerance at these times is low. Stick to fixed income and gold.

On the other hand if you are not near any financial goal, your risk tolerance is correspondingly higher and equity can help you grow your wealth.

4. Don’t Buy into Biases

There are 3 key biases that we all sometimes fall prey to. These are the confirmation bias, the hindsight bias and herd behaviour.

1. Confirmation bias is the kind of selective thinking that will make you filter and pay more attention to information that supports the opinions you agree with, while ignoring or rationalizing away the rest. This can cause you to have an incomplete and often inaccurate impression of the matter at hand.

In investing, this bias means that you would be more likely to seek out information that supports your original opinion of an investment, rather than read all the information available and assess it fairly. So if your neighbor tells you that now is the perfect time to buy into one particular stock, where you can make a ‘killing’, and you agree with him, you will automatically find yourself hearing, reading or looking up more positive information about the company, such as a low debt-equity ratio, a low PE and so forth.

2. Hindsight bias means that a person believes, in hindsight, that an event was completely predictable and obvious, when in fact it could not have been reasonably predicted. An example of this is the technology bubble of the late 1990s. In hindsight today, people might say that it was obvious that it was a bubble. But the fact of the matter is, if it was obvious that it was a bubble, it should not have escalated and later burst.

In investing, this is one of the most dangerous mindsets you can have. It leads to overconfidence, and overconfidence invariably leads to losses.

3. Herd behaviour can be best explained with a real life example.
In the early 1600s, the tulip was brought to Europe from the Ottoman Empire. It quickly became a status symbol, and soon Holland’s upper class was competing for the rarest and therefore most expensive tulip bulbs. In the 1630s, tulips were being traded on stock exchanged of various Dutch cities, leading to open participation and speculation on the prices of tulips. Soon, a single tulip bulb cost more than 10 times the annual salary of skilled Dutch craftsmen. At one point, a single rare tulip bulb commanded up to 12 acres of land. When prices collapsed suddenly, many people were financially ruined.
This is the effect of herd behavior.

It began in the financial world in the early 1600s with tulipomania and has been responsible for leading investors to make huge losses, or in the worst case scenario, go bankrupt, ever since then.
We saw it just recently in India, albeit not in a very big way, with the highest NAV guaranteed insurance plans. There’s a reason these schemes have now been banned. Remember, herd behavior, as tulipomania, the dotcom bubble and any other bubble since then will indicate, is not usually a profitable investment plan. Don’t assume that just because everyone is doing it, means it makes any sense at all. Stick to your plan, invest in products you understand, and stay away from biases.


To sum it up, investing is not rocket science and a market fall is not a permanent thing. Take it as an opportunity to buy low, if equity exposure is what your portfolio needs. Follow your investment rules, stay calm, and remember to take a deep breath before you make any sudden moves.
Source : personalFN

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